Inflation, Depreciation and NPV

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olajideanuoluwa001

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Please how is an increase in inflation likely to reduce the tax saving an investor benefit?
I believe an increase in inflation reduces the real value of the cash flow, depreciation and also the tax paid on them, so it should not lead to a transfer of resources from the investor to the government.
Please help explain this part.
 
Good point. I’ll add a similar statement I read that confuses me.
Both fixed costs and depreciation should be inflation adjusted because inflation reduces the value of tax savings including depreciation.
 
krokodilizm wrote:
Good point. I’ll add a similar statement I read that confuses me.
Both fixed costs and depreciation should be inflation adjusted because inflation reduces the value of tax savings including depreciation.
Click to expand...
Exactly. An increase in inflation which led to an increase in both fixed cost and depreciation should lead to an increase in tax savings due to the increase in depreciation expense, and thus a transfer of resources to the investor.
Dont know why the corriculum is saying otherwise.
 
olajideanuoluwa001 wrote:
krokodilizm wrote:
Good point. I’ll add a similar statement I read that confuses me.
Both fixed costs and depreciation should be inflation adjusted because inflation reduces the value of tax savings including depreciation.
Click to expand...
Exactly. An increase in inflation which led to an increase in both fixed cost and depreciation should lead to an increase in tax savings due to the increase in depreciation expense, and thus a transfer of resources to the investor.
Dont know why the corriculum is saying otherwise.
Click to expand...
Hi mate! At first, I am glad to hear you:)
IMO. Just try think about tax credit (tax savings) as about any other saving. In accelerating inflation environment those tax savings will be reduced. So, inflation may be considered as a kind of additional “taxation”. Here we are talking about tax credit, not about tax liabiilty in which case an accelerated inflation would have an opposite impact but in this case Authority will simply increase nominal tax rate.
“Inflation is taxation without legislation”
Milton Friedman
 
Flashback, yea, its good to read from you as well.
Logically, your explanation make sense, I have also analysed it from this angle.
So “if inflation increases, say a real estate asset, it will increase in value right. Also, we expect the expenses in maintaining the asset to increase as well as depreciation.
So, let us try with figures..
Say the value of an asset is 100 without inflation, with depreciation being 25% of the asset value, as well as a tax rate of 40%.
Depreciation expense = 100 * 25% = 25
Tax savings = 25 * 40% = 10.
Now assume inflation increases the net value to 120,
Dep expense = 120 * 25% = 30
Tax savings = 30 * 40% = 12.
So, can you see my point, tax savings increases due to the fact that the tax rate remained unchanged.
Maybe i am seeing this the wrong way though, but i really need an intervention here..
So back to you Flashback..
 
In my view what the statement claims is this:
In an inflationary environment if your sales prices increase but fixed costs and depreciation remain unadjusted* you will end paying more tax. So adjust these two also to keep your margins stable!?
*these are predetermined and are not affected by inflation
 
Mary is reviewing cash flow projections of an agricultural project and the forecasted cash flows are shown in Exhibit X. Mary receives a request from her manager, Lamb, to change the cash flows from nominal to real. She decides to remove inflation effects from the sales, variable cost, and salvage value figures, but not to adjust either fixed costs or depreciation.
Mary’s inflation adjustments to depreciation and fixed costs are most likely:
A. correct.
B. incorrect because both should be adjusted.
C. incorrect because only fixed costs should be adjusted.
Answer: B
Both fixed costs and depreciation should be inflation adjusted because inflation reduces the value of tax savings including depreciation.
 
olajideanuoluwa001 wrote:
Flashback, yea, its good to read from you as well.
Logically, your explanation make sense, I have also analysed it from this angle.
So “if inflation increases, say a real estate asset, it will increase in value right. Also, we expect the expenses in maintaining the asset to increase as well as depreciation.
Click to expand...
At first, if we are talking about prior purchased asset before inflation rate increase, nominally everything remains the same but a project tax savings will be really adjusted by an additional inflation impact. Consider it as an additonal tax which was not considered at the moment of starting project. Simply you really has a cash stream which worth less than prior and this cash flow stream maybe would not be sufficient as supposed to be by starting a project. This fact may have significiant impact on all project fundamental measures, NPV, IRR and other.
olajideanuoluwa001 wrote:
So, let us try with figures..
Say the value of an asset is 100 without inflation, with depreciation being 25% of the asset value, as well as a tax rate of 40%.
Depreciation expense = 100 * 25% = 25
Tax savings = 25 * 40% = 10.
Now assume inflation increases the net value to 120,
Dep expense = 120 * 25% = 30
Tax savings = 30 * 40% = 12.
So, can you see my point, tax savings increases due to the fact that the tax rate remained unchanged.
Click to expand...
If you mean on future asset purchasing and possible inflation impact on project’s CF, in future projects based on adjusting to new inflatory circumstances, each stream would be offset mutually by an inflation impact (eg. sales increase, new equipment prices increase as well as all costs related to it, nominal tax rate will likely to be increased). These would be considered by starting each new project so it doesn’t make a sense on current situation.
However, reducing the tax shield in the accelerating inflatory environment is the current (started) project’s issue not related to the future projects.
 
Current inreased project costs (maintenance, etc.) due to impact of higher inflation would be offset by increase in sales.
 
I assume it is largely related to the Fixed Assets already on the books that you bought at old prices.
When I was a younger man, I did some Fixed Assets accounting work at AT&T. Today they have ~$124 billion in Fixed Assets, with virtually all of it depreciable. At a 30% tax rate, this translates to about $80B in tax “savings”. That sounds like a lot, but if we hit Weimar Germany style inlfation, that $80 billion would be worth a lot less.
 
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